Amid scenes reminiscent of the financial crisis of 2008, markets reacted with
a mixture of disbelief and anger to a German government ban on short selling
of European Union government debt and banks.

Billions of pounds were wiped off the value of shares as the main European indices on Wednesday dropped on the back of large-scale selling by institutions shocked and spooked by Germany's actions.

The FTSE 100 fell 2.8pc, while France's CAC 40 index lost nearly 3pc of its value. German stocks fell too, with the Dax dropping 2.7pc, led in part by falls in banking shares, proving the ineffectiveness of the ban.

Stefan Isaacs, at fund manager M&G summed up the mood for many, describing the midnight ban by BaFin, the German regulator, as "draconian and uncoordianted".

"The fact that the ban was announced after the European market closed and was implemented only a few hours later is nothing short of reckless and has the market speculating about larger, unknown problems."

The grim mood was matched in currency and fixed income markets, with the euro hitting a four-year low against the dollar of $1.2144 in Asian trading, beforerallying to $1.24 on rumoursthat the Swiss National Bank or European Central Bank had entered the market.

Even experienced bond traders were left uncertain how to react and several major investment banks opted to delay opening their market making desks until some sort of order returned.

"Nobody has a clue what is going to happen next," said Anthony Peters, a strategist at Swissinvest.

"Politicians have shown they have no understanding of markets. They are firing the wrong calibre gun, at the wrong target and they are missing."

With echoes of the summer of 2007 when the credit crunch first began and September 2008 in the aftermath of Lehman Brothers collapse, the inter-bank lending markets have again showed signs of strain as financial institutions became increasingly weary about lending to one another.

One London-based credit trader said only top-rated financial institutions were comfortably accessing the overnight borrowing markets, as banks again worried about the exposure of their rivals to bad debts, in this case Greek bonds.

The overwhelming sense of confusion was compounded by the reaction of other European governments to the German ban, as complaints were voiced about a lack of consultation ahead of the surprise announcement.

Christine Lagarde, French finance minister, said France would not be following Germany's lead, and issued a thinly veiled attack at the country's unilateral approach.

"I think we should really request the views of those governments affected by this measure," said Ms Lagarde.

Michel Barnier, the EU's internal market commissioner, made his own coded attack on "these measures", saying they would have been more effective if they had been coordinated at the "European level".

"It is important that member states act together and we design a European regime to avoid regulatory arbitrage and fragmentation both within the EU and globally," said Mr Barnier.

The sense among EU members that Germany had acted solely in its own interests was compounded yesterday as an auction of £3.7bn of German government bonds saw the country issue new debt at the cheapest rate since 1998, helped largely by the so-called "short squeeze" created in the bond market by the short selling ban, which forced many investors with short positions to buy debt.

Coming a day after Spain struggled with a debt sale of its own, many EU governments will have found it hard to escape the conclusion the German ban was a partly a cynical attempt to improve Germany's finances.

Questions have also been raised about how effective the ban would actually be. Much of the trading in German bonds and shares does not actually take place within the country, therefore the ban will not have stopped many banks or hedge funds from continuing to short sell EU government debt or German banking stocks.

It was even unclear whether the international subsidiaries of German financial institutions would be effected by the ban, meaning German banks might actually be able to short their rivals despite the ban.

Naked short selling, which involves investors selling a share or a bond without actually borrowing the security, has come in for heavy criticism from a variety of senior European politicians in recent months, with many blaming the financial woes of the region on speculators, however investors have reacted with scorn to what they say is a populist and simplistic critique.

"Yes, you can reduce speculative flows in certain financial instruments by banning them, but this does little if anything to address the underlying issues," said Simon Ballard, senior credit strategist at RBC Capital Markets.

"Let's be clear here; it is not the financial markets that created the structural problems of the Eurozone, it is the politicians who set the parameters of the single currency regime in the first place."